Notes on Spending and Retirement
Published On: April 17, 2019
Written by: Ben Atwater and Matt Malick
This is the third essay in a series on retirement planning. The first was a general overview of retirement planning and the second focused on health care spending in retirement. In today’s edition, we will discuss spending (expenses) in retirement. We plan two more essays in this vein, one on income and another on risk tolerance.
Although saving and investing are incredibly important, as you approach retirement, it’s vital to take a closer look at spending. For most people, the last decade of work will require peak savings and a sharp eye on current and future (retirement) expenses.
The U.S. Bureau of Labor Statistics estimates the average household spends most of its income (65%) in four areas – housing (28%), transportation (14%), food (13%) and health care (10%). For more affluent households these percentages tend to drop as more money is spent in luxury areas like travel, collectibles, fashion, etc.
In our experience, people tend to underestimate their spending. This phenomenon is almost universal. We believe this stems from an exclusion of “one-time” expenses, which, unfortunately, tend to occur fairly regularly into retirement. This year, you may need to replace the roof on your home, which may hold up for the rest of your life. But next year, you’ll need a new car or the basement will flood or a child will need support. In our experience, “one-time” expenses come in a variety of forms and happen more frequently than we’d like.
Budgeting is extremely important, but we can very easily trick ourselves into inherently believing our budgets. Therefore, we should check them with the following eye-opening exercise . . .
Take your household gross income, then subtract the taxes you pay and the savings you set aside each year. Remember, this savings must be in an account somewhere or an actual investment. Use three years of data for this exercise. Most mass affluent families will be quite surprised with the extent of their spending. Gross wages minus taxes minus savings equal spending. This is an inescapable equation.
After performing this exercise, it’s appropriate to revisit your budget and figure out where the holes exist. Said hole is often a “one-time expense.” Budgets should include an extraordinary expense line that is equal to your average extraordinary expenses over the last three to five years. These expenses typically do not go away with retirement.
A common example that people don’t count as spending and mischaracterize as an investment is the purchase of a vacation home. Purchasing a vacation property is not only a current expense but it is also an obligation to incur future annual expenses (property taxes, mortgage, upkeep, etc.). There is nothing inherently wrong with a vacation home. As a matter of fact, it’s a great thing, but you need ample money to truly afford one without impacting your retirement plan. If you plan to rent the second home to cover its expenses, be careful that your analysis of revenue and expenses is accurate and realistic.
To analyze how much spending impacts retirement, let’s consider a married couple who plans to retire in less than three years. This couple, we’ll call them the Hasselhoffs, expect to have after-tax spending of $72,000 per year plus another $10,904 in Medicare-related expenses. In today’s dollars, that’s a total of $82,904 in annual after-tax spending. After retirement, at age 68, the Hasselhoff’s will receive about $53,000 per year in pre-tax Social Security. They have approximately $1 million invested in retirement plans with a balanced growth asset allocation and are saving about $30,000 per year to these plans over the next couple of years.
In this scenario, the Hasselhoff’s are in great shape for retirement. However, if we test their non-healthcare after tax spending at $92,000 per year, a $20,000 increase, their probability of success, using statistical testing, falls below the confidence level in our analysis. Now $20,000 is a big number in this case study, but it’s also a realistic “extraordinary” expense in a year. If the Hasselhoffs didn’t account for extraordinary expenses in their budgeting process, then they may face some trouble in retirement. If they did truly account for extraordinary expenses in their $72,000, then they are well-positioned for retirement.
A general rule of thumb for retirement spending, replacement income should be about 80% of your working income. This makes intuitive sense if you assume you’re saving 15% of your pay now and your taxes will fall by roughly 5% after retirement, leaving 20% (15% + 5%) less retirement “income” to replace your working wages.
Another good rule to consider is, the lower your household income, the higher the percentage of replacement income you will likely need. Some folks may need 100% replacement income, while higher earning households might need 60%, depending on your taxes and saving rates while you’re working.
An analysis by Fidelity Investments suggests average spending after age 65 drops to $46,295 from $58,708 before 65. We think a lot of this is forced. In other words, people are lowering their lifestyle in order to make retirement feasible. There is nothing wrong with this approach, but it’s better if this is a long-term plan versus a forced decision.
Fidelity also finds that average household spending does trend lower over time. This seems logical as people age they have less ability and less desire to undertake expensive activities. Healthcare costs, on the other hand, do tend to increase during retirement. If you’re on a good employer healthcare plan and you retire and start paying for Medicare then healthcare costs will probably spike as Medicare could be more expensive than large employer plans. This could cause an immediate increase in healthcare spending at retirement.
Evaluating expenses in retirement is a lot harder than people think. We’re happy to help. Please don’t hesitate to contact us.